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What Are Stochastic Indicators

Introduction

Stochastic indicators belong to the family of oscillators. Oscillators are momentum indicators with lower and upper bounds, usually used by traders to identify patterns of upward or downward momentum to make trading decisions. When oscillator values approach the upper or lower band, they signal overbought or oversold positions in the market.

Predominantly, in statistics, stochastic means having randomness or a certain level of probability, whereas in trading, it is referred to as an indicator of technical analysis. This specifically means that the current price of a security can be related to a range of possible outcomes within its relative price band over a specified time period.

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How to read a stochastic indicator?

Stochastic indicators are easy to interpret and, hence, are one of the most widely used indicators to this day. From beginners to veteran traders, most of them use this indicator while chart reading to understand a stock's momentum. It is usually measured over a 14-day time period and is measured between 0 and 100 units. If the price goes below the lower bracket of 20, it indicates overselling and that going long can be a good trade. On the other hand, if the stochastic oscillator hits the upper bracket of 80, it indicates overbuying in the market and going short would be a good trade.

The stochastic indicator, when drawn over a candlestick chart for security, has two lines. One is the original, stochastic line of the security, and the other is the 3-day moving average of the security over the previous three days. Whenever there is an intersection between the two lines, it marks the beginning of a trend reversal for that stock. Similarly, whenever there is a divergence between the two lines, it is also indicative of yet another possible trend reversal. The two lines in tandem represent a series of convergences and divergences that reflect the price momentum and trends of security.

What is a Relative Strength Index?

The Relative Strength Index (RSI), a widely used price momentum indicator that is very similar to a stochastic indicator. Both RSI and stochastic oscillators are used in tandem by traders to make their trading decisions more robust. The only absolute difference between the two indicators is that the RSI focuses more on the momentum of the security, whereas the stochastic oscillator more appropriately dignifies trend patterns.

Conclusion

Stochastic indicators are valuable tools for traders seeking to identify trend lines and momentum in the financial markets. Both beginners and experienced traders find stochastic indicators easy to interpret and highly effective for chart reading. As with any technical analysis tool, it is crucial to use stochastic indicators in conjunction with other analysis methods and risk management techniques.